JPMorgan's $13B Penalty Could Be A Huge Blow to Struggling Homeowners

JPMorgan's $13 billion settlement with the Justice Department is supposed to be punishment for the bank's violations in the sale of mortgage-backed securities. But it could end up far worse for the struggling homeowners some of the money is supposed to assist. While JPMorgan could be allowed to write off the penalty as a tax deduction, ordinary people who receive mortgage relief as part of the settlement could get hit with a giant tax bill, making the debt relief benefit irrelevant, if not actively harmful. This is because Congress, through their sheer inaction, will soon allow this type of mortgage relief to be taxed as income.

This is an unintended consequence of the Justice Department's settlement with JPMorgan Chase, but they have a chance to avoid letting this topsy-turvy outcome occur. They could insert language into the settlement so the mortgage relief is not taxed, but given who participates in such negotiations—bank lawyers, not homeowners—it’s highly unlikely. And it shows once again how utterly tilted the justice system is toward the rich and connected.

The Mortgage Forgiveness Debt Relief Act expires at the end of 2013, and there’s no expectation that our broken Congress will extend it further (the House GOP can’t even find enough bills they want to pass to fill the schedule between now and Christmas). The law, first passed in 2007 in the wake of the housing bubble collapse, exempted homeowners from paying taxes on any mortgage debt cancellation, either from a reduction in the principal of the loan, or from mortgage debt forgiven in conjunction with a property sale. But sources in Congress have heard of no effort to renew the law. It could resurrect itself as part of a broader “tax extenders” package that Congress passes every year, but there’s no guarantee, especially with delinquencies and foreclosures somewhat reduced since the worst days of the crisis.

But millions of families remain at some stage of delinquency on their loans, and have been trying for years to secure mortgage debt relief to stay in their homes. These are the people who will receive aid as part of the JPMorgan settlement. Reports claim that homeowners in Detroit, where JPMorgan has a significant banking presence, will receive a lot of the help, at the Justice Department’s request. But because the settlement has yet to be finalized or approved by a judge, homeowners would not be identified and granted mortgage relief until next year, in all likelihood, after the Mortgage Forgiveness Debt Relief Act has expired.

That means that the money JPMorgan will pay as aid to homeowners, could, thanks to our dysfunctional politics, end up hurting them even further. Here’s an illustrative example. Say an individual Detroit homeowner earning $40,000 a year gets a principal reduction of $100,000, roughly the average principal reduction in the National Mortgage Settlement, a previous deal that offered consumer mortgage relief as part of a penalty for bank misdeeds. In the tax year 2014, that homeowner would record an income of $140,000, and their resulting tax bill, according to this calculator, would be $29,693, or nearly three-quarters of the homeowner’s annual income. Homeowners struggling to stay in their homes typically do not carry large amounts of cash reserves to pay off tax bills; they wouldn’t be desperate for mortgage debt relief if they did.

The IRS notes that there is a hardship exemption to the taxation of mortgage debt cancellation, but the individual has to basically prove insolvency, that their total debts exceed the fair market value of their total assets. This is the functional equivalent of bankruptcy, and requires special reporting and documentation. Low- and moderate-income homeowners don’t necessarily have the tax planning experience or resources to deal with this easily. They could also, of course, reject the aid—but it would require an awful lot of financial savvy in order to know to do so.

It’s almost inconceivable that a settlement supposed to penalize a major bank for selling shoddy mortgages would end up giving the bank a tax advantage while punishing homeowners with a huge, new tax liability. And, in fact, this does not have to be the outcome. When the Mortgage Forgiveness Debt Relief Act almost expired last year, Brad Miller, a Congressman at the time, theorized that if debt relief mandated in a settlement was structured as compensatory damages, it may not be subject to taxation. Much like the way the Justice Department could write language demanding that JPMorgan does not take a tax deduction from the damages, it could conceivably design the settlement to exempt homeowners from the tax liability.

But no homeowners or homeowner advocates are sitting in the negotiation room where the settlement language is getting hammered out. In fact, that settlement room is populated with Justice Department officials who previously worked for law firms that represented banks in white-collar defense. The revolving door between Washington and Wall Street ensures a very specific perspective at the negotiating table. For example, it appeared the Federal Housing Finance Agency (FHFA), in a recent $5.1 billion settlement with JPMorgan, closed a loophole enabling the bank to charge the Federal Deposit Insurance Corporation (FDIC) for any losses incurred by Washington Mutual, which JPMorgan purchased from an FDIC receivership in 2008. However, the Wall Street Journalreported that, while JPMorgan could not seek compensation from the FDIC “in its corporate capacity,” the FHFA failed to prevent the bank from recovering damages from the FDIC receivership. When well-paid bank lawyers get in a room with regulators and law enforcement personnel, they usually find ways to limit their damage. Homeowners don’t get the same treatment.

The Justice Department claims that their deal with JPMorgan Chase will be a template for future enforcement actions over mortgage-backed securities violations, which spanned the entire industry. Indeed, at least nine banks are currently under scrutiny for their mortgage practices. So the horrible outcome of a government settlement burdening homeowners with giant tax bills could affect more than just JPMorgan Chase customers, unless the Justice Department arranges the settlement explicitly to limit such inequities.

Of course, cash settlements subject to gamesmanship will always come up short as a true penalty for misconduct or a deterrent for future behavior. The punishment deserved in the case of a massive fraudulent scheme that nearly collapsed the U.S. economy involves jail time, but the government has simply been reluctant to prosecute. As we can see, when you penalize fraudulent actors with cash, they can always find a way to make someone else pay. Homeowners caught in the crossfire don’t have the same luxury.